Explaining EBITDA to Non-Financial Start-Up Owners

The other day, two friends of mine—both brilliant start-up owners but self-confessed non-financial types asked me to explain EBITDA. They had heard the term in meetings and felt it sounded important, but they weren’t sure what it meant or why it mattered.

So, I gave them a simple, no-jargon explanation over coffee. Let me share the same with you, using a real-life example.

What Is EBITDA, Really?

“First things first, EBITDA stands for Earnings Before Interest Taxes Depreciation Amortization."

Sounds complicated, right? But it’s not. Think of EBITDA as a measure of how much money your business makes from its day-to-day operations before you consider things like loan payments, taxes, or the aging of your equipment. It’s a way to zoom in on your core profitability.

Why Is EBITDA Important?

Imagine you’re talking to a potential investor or lender, they don’t care about your specific tax situation or how much interest you’re paying on your loans. What they care about is how well your actual business is doing. EBITDA helps them see that clearly.

It’s like looking at the heart of your business without the distractions of other costs.

A Real-Life Example: Coffee Shop Hustle

One of my friends runs a small but thriving coffee shop. Last month, they made $30,000 in revenue from coffee sales. Here’s how the costs broke down:

• They spent $9,000 on coffee beans, milk, and cups (cost of goods sold).
• Another $6,000 went to staff salaries and rent (operating expenses).

To calculate their EBITDA, we took the $30,000 revenue and subtracted these two costs:

• $30,000 – $9,000 (cost of goods) = $21,000
• $21,000 – $6,000 (operating expenses) = $15,000 EBITDA

This $15,000 represents the income generated purely from running the coffee shop, before considering other expenses like loan payments, taxes, or saving for a new espresso machine.

By looking at this EBITDA, we get a clear view of how well the coffee shop’s day-to-day operations are performing, without getting distracted by other factors.

What About Other Costs?

One of my friends chimed in, “What if I had to pay a bank loan or save for a new espresso machine?”

Those costs like loan interest or savings for equipment replacement aren’t included in EBITDA. It focuses only on the earnings from your operations, ignoring non-operational costs like taxes, interest, or depreciation.

To put it simply, EBITDA shows how well your shop is running, while net income tells you what’s left after all expenses are factored in.

Why EBITDA Is a Good Measure

“So, why is EBITDA such a popular metric?”

1. Focus on Core Operations: It strips out factors like taxes and financing costs, giving a clear view of how your core business performs.
2. Comparability: Since it removes items that vary widely between businesses—like tax rates or debt structures EBITDA makes it easier to compare companies, even in different regions or industries.
3. Investor-Friendly: Investors love it because it quickly highlights operational efficiency without getting bogged down in accounting complexities.

It’s like comparing apples to apples across businesses, regardless of their unique financial circumstances.

The Cons of EBITDA

“But it’s not perfect,” EBITDA has its limitations:

1. Ignores Important Costs: It doesn’t account for debt payments, taxes, or the replacement of aging assets. For instance, your coffee shop’s worn-out espresso machine doesn’t show up in EBITDA, but replacing it could be a significant expense.
2. Not a Cash Flow Measure: Just because your EBITDA is high doesn’t mean you have cash in the bank. It’s possible to have strong EBITDA but struggle with liquidity if your other expenses are too high.
3. Overly Optimistic: Some businesses use EBITDA to paint a rosier picture of their financial health by excluding costs that are very real and unavoidable.

So while EBITDA is helpful, it’s only part of the financial story.

Think of EBITDA as your operational scorecard, It’s a great way to measure how well your business is running, but it’s not the full picture. To truly understand your financial health, you need to look at other metrics like cash flow and net income too.

And that’s the beauty of it. Whether you’re running a coffee shop, a tech start-up, or any small business, understanding EBITDA can help you better communicate your business’s performance.

This is just one perspective on EBITDA. Finance professionals, entrepreneurs, and investors what are your thoughts? How do you use EBITDA, and what other metrics do you find invaluable? Let’s discuss this in the comments! Your insights might help someone else on their business journey.